DOCSLIB.ORG

The Political Economy of Incentive Regulation: Theory and Evidence from US States Carmine Guerriero

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
The Political Economy of Incentive Regulation: Theory and Evidence from US States Carmine Guerriero The Political Economy of Incentive Regulation: Theory and Evidence from US States Carmine Guerriero NOTA DI LAVORO 34.2008 APRIL 2008 PRCG – Privatisation, Regulation, Corporate Governance Carmine Guerriero, Faculty of Economics, University of Cambridge This paper can be downloaded without charge at: The Fondazione Eni Enrico Mattei Note di Lavoro Series Index: http://www.feem.it/Feem/Pub/Publications/WPapers/default.htm Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=1123438 The opinions expressed in this paper do not necessarily reflect the position of Fondazione Eni Enrico Mattei Corso Magenta, 63, 20123 Milano (I), web site: www.feem.it, e-mail: [email protected] The Political Economy of Incentive Regulation: Theory and Evidence from US States Summary The determinants of incentive regulation are a key issue in industrial policy. I study an asymmetric information model of incentive rules selection by a political principal endowed with an information-gathering technology whose efficiency increases with the effort exerted by two accountable supervisors (a regulator and a judge). This set up captures the institutions of several international markets. The model predicts that reforms toward higher powered rules are more likely the more inefficient (efficient) is the production (information-gathering) technology, the less tight is political competition and the greater are pro-consumer supervisors’ incentives. This prediction is consistent with evidence based on US electric power market data. Keywords: Incentive Schemes, Accountability Rules, Regulatory Capture JEL Classification: D73, H11, L51, K2 I don’t know how to thank Toke Aidt, Yannis S. Katsoulacos, David Newbery, Michele Polo, Andrea Prat, Mark Schankerman, Guido Tabellini, David Ulph, and Melvyn Weeks for precious discussions on earlier drafts. I am deeply grateful to Tim Besley, Andy Hanssen and Junseok Kim for the data provided and for encouragement and to seminar participants at LBS, Cambridge University, at the 2006 EEA meeting in Vienna, at the 2007 Public Choice Society meeting in Amsterdam, and at 2007 EARIE meeting in Valencia for comments. I would like to acknowledge financial assistance from the Ente Luigi Einaudi, the Felice Gianani Foundation and the Marco Fanno Foundation. Address for correspondence: Carmine Guerriero Faculty of Economics University of Cambridge Sidgwick Avenue CB3 9DD Cambridge UK E-mail: [email protected] 1. Introduction In regulating a natural monopoly with unknown costs, governments should select incentive rules optimally trading off informational rents extraction and cost- saving inducement (Laffont and Tirole, 1993). Yet, politicians put a greater or lesser weight on the firm’s profit depending on whether their constituency is dominated by pro-shareholder or pro-consumer sentiments. Besides, the details of incentive contracts are designed by public officials who are accountable either to professional peers or to specific groups of voters and not to the society at large. The US electric power market (along with other US markets) is a case in point. Major regulatory reforms, included the recent introduction of incentive regulation, are politically initiated but subject to lengthy quasi-judicial hearings aimed at gathering both the necessary technical information and the consensus of all interested parties. While regulators and judges, who can either be appointed or elected, preside over the hearings, the final policy position is proposed de facto by an independent staff. This institutional design is not unique to the US and, in the aftermath of the recent South-American and European privatization wave, a rising need for higher transparency of the regulatory process has exported beyond American boundaries a similar combination of independent staffs and accountable top-level regulators and judges (see Newbery, 2000).1 How, therefore, do public officials’ incentives and task-specific motivations shape regulatory reforms and 1Remarkably, the Competition Act of 1998 and the Utilities Act of 2000 reformed the UK gas and electricity market institutions introducing a top-level board of three officials (GEMA) appointed by the Secretary of State and supported by an independent staff (Ofgem). The latter proposes the policy position and is subject to a strict transparency requirement which, in turn, “provides the hook for judicial review” (OECD, 2002). how does this mix of incentives and motivations interact with the rent extraction- efficiency trade off and the political environment? To answer these questions, I provide a theoretical framework bridging the canonical principal-agent model of incentive regulation (Laffont, 1996) with two recent strands of political economics literature. While the first one compares accountable and non-accountable public agents (Alesina and Tabellini, 2007 and 2008), the second contrasts career and legacy concerns in politics (Maskin and Tirole, 2004). Bringing together these bodies of economic theory, I study the incentive rules selection problem performed by a principal faced with a monopoly with unknown costs. The principal is endowed with an information-gathering technology whose efficiency rises with the effort exerted by a regulator and a judge, whom hereafter I will call supervisors. Supervisors respond to implicit or accountability incentives and intrinsic or legacy motivations. Implicit incentives force supervisors to select effort looking at the ballot box (at the preferences of their professional peers) if elected (appointed) but not at the power––in terms of cost reducing effort––of the rule selected by the principal. The model predicts that, under a mild condition on the distribution of supervisors’ random abilities, elected supervisors exert more effort than appointed ones. These pro-consumers selection incentives are fuelled (curbed) by judges’ fairness motivations (regulators’ desires of pursuing a career in the industry). The principal foresees the effect of implicit incentives and intrinsic motivations on the expected probability of remaining uninformed, and, accordingly, the power of equilibrium incentive rules increases (decreases) with fairness (revolving door) motivations, and is greater when supervisors are elected. Also, if the principal is concerned by the long run efficiency of the market, the power of the optimal rules 3 increases (falls) with the efficiency of the production (information) technology. Finally, if the principal is one of two competing parties, incentive rules are also sensitive to tightness of political competition and to voters’ preferences. To test this set of predictions, I analyze US electric power market data at the state level. Consistently with the model, performance based regulation (PBR hereafter) is found where regulators and judges are elected, political competition is less harsh, generation more costly and regulatory resources more abundant. There are three main contributions by this paper. First, I formalize and test a theory of complementarities among supervisors’ implicit and firms’ explicit incentives arising endogenously from the contractibility of the firm’s allocation as opposed to the non-contractibility of supervisors’ performance. I also offer one of the first accounts of the relation between public officials’ intrinsic motivations and regulatory policies (see also Ka and Teske, 2002; Guerriero, 2008). Second, I provide evidence that the observed regulatory institutions reflect both efficiency and strategic political concerns. This is particularly noteworthy because, even if several studies have used cross-state telecommunications (see Ai and Sappington, 2002; Eckenrod, 2006) and cross-country electricity data (see Jamasb and Pollitt, 2001) to show that PBR can deliver lower rates and higher profits, no previous paper has tried to evaluate the determinants of reforms toward incentive regulation.2 Finally, I also propose a first test of the endogenous effect of incentive rules on US electricity rates using a GMM estimator. This last 2 Recent empirical tests look at the determinants of electricity market restructuring experiences in the US (Ka and Teske, 2002) and around the world (Steiner, 2004) but without providing a formal theory of regulatory actors’ incentives as derived by market institutions. Hanssen (2004) provides a first empirical result bridging strategic dynamics and institutional reforms. 4 exercise shows that rates are unaffected by PBR and suggests an investment- based explanation of the incentives revolution, stressing also the relevance of an endogenous regulatory institutions research program for policy evaluation. The remainder of the paper is organized as follows. Section 2 describes the institutions governing the pricing process in the US electric power market. The first part of section 3 clarifies the effect of supervisors’ incentives and motivations on incentive rules. Next, the benevolence assumption is relaxed and the strategic determinants of regulatory reforms are evaluated. Section 4 tests the model’s implications, looking at the wave of reforms toward PBR that has interested the market in recent decades. Section 5 concludes. All proofs, tables and a detailed description of the data are gathered in the Appendix. 2. Institutions Natural local monopolies and incentive rules.––Investor-owned electric power utilities (IOUs hereafter) account for over three-fourths of the electricity sales of the US electricity market. While jurisdiction over both interstate transmission and wholesale
Load more

Recommended publications
  • Web Small Image.Qxd
    Bulletin no75 Summer 2000 RESEARCH 2 Research Overview: A retrospective look at research in the Centre’s 27 Including Developing Countries in a Consensus for the WTO. In CEPR seven Programme Areas. Policy Paper No.4, Zhen Kun Wang and Alan Winters present an eight- point plan that they believe will bind the developing countries more 7 Reducing the Working Week: A Free Lunch or Irrational Ideology? securely into the World’s trading system. The French government's decision to reduce the working week from 39 to 35 hours has attracted criticism from the European Commission, IMF 30 The Eurosystem: Transparent and Accountable. In CEPR Policy Paper and OECD. Two recent discussion papers, one theoretical the other No.1, Willem Buiter claimed that the ECB is not sufficiently open, empirical, address the possible outcomes of this policy. transparent and accountable, and that its strategies and objectives need clarifying. In CEPR Policy Paper No.2, Otmar Issing argued that 10 Does Exchange Rate Stability Increase Trade and Capital Flows? The Buiter was wrong. empirical evidence regarding exchange rate regimes and trade flows is far from conclusive. A recent Discussion Paper takes a general equilibrium approach to the question of exchange rate uncertainty, MEETINGS In this issue concluding that trade is not necessarily higher under a fixed exchange rate system. 32 European Monetary Union: A Trojan Horse to Liberalize Labour Markets. At a lunchtime meeting, Michael Burda argued that one 12 Is the Level of Unemployment Insurance Self-Perpetuating? Why consequence of EMU would be that real rigidities in the labour market do countries choose different levels of unemployment insurance? A would fall while nominal rigidities in the goods market would increase.
    [Show full text]
  • Uniformity Versus Selectivity in Indirect Taxation*
    ECONOMICS AND POLITICS 0954- 1985 Volume 2 March 1990 No. I UNIFORMITY VERSUS SELECTIVITY IN INDIRECT TAXATION* NICHOLASSTERN I. INTRODUCTION There are (at least) five groups of arguments which might suggest that indirect taxes should be at a uniform proportionate rate. The first is theoretical and concerns results which show that, under certain assumptions, uniform indirect taxation is an optimum solution in the sense of Pareto efficiency or a combination of equity and efficiency as reflected in a social welfare function. Related results characterise conditions under which movements towards or away from uniformity are welfare improving. The second concerns our ignorance of the information on which theory suggests differential rates of tax should be based. The third group is administrative where it is argued that uniform taxes are simpler to organise and collect, and provide less scope for evasion, than selective taxes. The fourth concerns the role of political and other influences, including unproductive or rent-seeking activities, where, it is suggested, the possibility of non-uniform taxes will lead to considerable opportunities for misuse of the tax system, including expenditure on lobbying by interested parties for special tax treatment. The fifth argues that it is wrong to discriminate between people (and thus goods) on the basis of their preferences. Most of the arguments in favour of uniformity have some serious content but, it will be argued, their proper evaluation requires an understanding of the assumptions underlying the theoretical results, an involvement with the empirical analysis of household behaviour and tax reform, and finally experience with how policy is formed and taxation administered.
    [Show full text]
  • David Michael Garrood Newbery, CBE, Phd., Sc.D., F.B.A
    CURRICULUM VITAE 31 May 2016 David Michael Garrood Newbery, CBE, PhD., Sc.D., F.B.A. Born: 1 June 1943 at Fulmer Chase, Bucks, England, Nationality: British, both parents British. Education: Portsmouth Grammar, 1954-1961. Best Science Candidate in Cambridge GCE A&S Level 1960. Scholar, Trinity College, Cambridge, December 1960, read for Mathematics Tripos 1961-63 (Finals, Part II 1963). Switched to read for Economics Tripos 1963-65. Formal graduation as B.A. 1964. Finals (Part II) Economics 1965. M.A. 1968. Ph.D (Cambridge) 1976. ScD (Cambridge) 2001 Career: Pre-elected to Churchill Teaching Fellowship, June 1965. ODI Nuffield Fellowship as an economist in the Treasury of the Tanzanian Government, 1965-66. Took up Fellowship and Directorship of Studies at Churchill October 1966. Appointed University Assistant Lecturer, Faculty of Economics, October 1966. University Lecturer, Oct. 1971. Tenure 1974. Reader in Economics, Oct. 1986. Director of Department of Applied Economics, 1988-2003. Professor of Applied Economics, Faculty of Economics, 1988- 2010, Professor Emeritus, 2010- , Research Director, Electricity Policy Research Group, 2006-, all at University of Cambridge; “10% position” as Professor II at Tromso University, Norway, 2011-2013; Research Fellow in the Centre for Sustainable Electricity and Distributed Generation in the Control and Power Research Group at Imperial College London Dec 2011- Visiting Research Associate at the Cowles Foundation, Yale University 1969. Positions: Ass. Prof. Stanford University Dec 1976-Sep 1977. World Bank, Washington, D.C. Sep 1981-Sep 1983: Div. Chief, Public Econ. Div.; Prof, Princeton, Jan-June 1 1985.Visiting Scholar, IMF Fiscal Affairs July-Aug 1987; Ford Professor UC Berkeley, 1987-1988; Visiting Professor, University of Southern Denmark, 2010-2011.
    [Show full text]
  • Economics Newsletter Layout SINGLE PAGES.Indd
    Economics Cambridge Cambridge Faculty of Economics Alumni Newsletter Welcome from Andrew Harvey Profi le: he fourth Alumni newsletter contains pieces on the Marshall and Stone lectures, new arrivals, conferences, Clare Spottiswoode CBE Tdistinguished alumni and visiting professors. We also The Swing of the Pendulum have an article by Angus Deaton on his experiences in 1960s Cambridge and another set of recollections on Cambridge 30 years later, from Tavneet Suri. Last year’s piece by Kenneth ank accounts, life insurance policies and gas Arrow about his visit in the academic year, 1963-64, prompted bills. These seemingly mundane yet crucially some correspondence about the so-called `secret seminar’. In Bimportant artefacts of contemporary living particular, Aubrey Silberston contacted me and we are delighted defi ne much of Clare Spottiswoode’s activities over to include an article by him on the topic. Any other views the past twenty years. She is often seen as the on this or other activities in times past would be more than consumers’ feisty standard bearer in the face of welcome! powerful business interests. But this is an image she rejects, saying fi rmly that her public interest Hamid Sabourian is stepping down from the Chairmanship of the Faculty, having served four years. He will shortly be escaping to Hong commitment and the role she plays are “to make Kong, where he will be spending some of his well-earned sabbatical sure the pendulum [of the market] does not swing leave. Richard Smith, our Professor of Econometric Theory and too far in one direction or the other”.
    [Show full text]
  • Advanced Public Economics II (Taxation) David L
    JANUARY 12, 2017 Econ 9460 Advanced Public Economics II (Taxation) David L. Sjoquist Spring 2017 Office: 433 AYSPS Phone: 404.413.0246 email: [email protected] Office Hours: By appointment Class Time: Thurs 4:30-7:00 PM Class Place: 127 Langdale Hall Public economics examines government tax and spending policies: what do governments do, what are the effects of these actions, and whether these effects are “good” or “bad”. Economics 9460 is part of a doctoral-level sequence in public economics, and focuses upon revenue issues, particularly taxation. The course describes the major taxes used by national governments; it analyzes the impacts of taxation on the allocation of resources, i.e., economic behavior; and evaluates the level and distribution of economic welfare. COURSE LEARNING OUTCOMES The student should be able to: describe and understand the major revenue sources (e.g., personal income tax, corporate income tax, taxes on consumption, and taxes on wealth); define, understand, and evaluate the principles of public finance in a federal system analyze the effect of alternative tax regimes on savings, labor, retirement, consumption, and investment decisions; define and understand the effects of taxes on the distribution of income (e.g., the theory of “tax incidence”); measure the incidence of direct and indirect taxes using both partial and general equilibrium models of tax incidence; define and understand concepts of “tax equity”, and be able to evaluate the equity of a tax and of tax systems; define and understand the effects
    [Show full text]
  • THE ECONOMICS of CONSANGUINEOUS MARRIAGES Quy-Toan Do, Sriya Iyer, and Shareen Joshi*
    THE ECONOMICS OF CONSANGUINEOUS MARRIAGES Quy-Toan Do, Sriya Iyer, and Shareen Joshi* Abstract—This paper provides an economic rationale for the practice of transfers of assets from the bride’s family to the groom’s consanguineous marriages observed in parts of the developing world. In a model of incomplete marriage markets, dowries are viewed as ex ante family, and second, enforcement mechanisms for informal transfers made from the bride’s family to the groom’s family when the contracts are stronger within kinship networks than outside promise of ex post gifts and bequests is not credible. Consanguineous unions such networks. The crux of our model is that a marriage is join families between whom ex ante pledges are enforceable ex post. The model predicts a negative relationship between consanguinity and dowries a contract in which two families make a long-term commit- and higher bequests in consanguineous unions. An empirical analysis based ment to support their offspring through gifts, bequests, and so on data from Bangladesh delivers results consistent with the model. forth. These also enhance the value of the match and, conse- quently, the social status of each family. However, once links I. Introduction have formed and are costly to sever, each family may now pre- fer to invest in alternative opportunities while free-riding on ONSANGUINEOUS marriage, or marriage between the other family’s investments. To overcome this time incon- C close biological relatives who are not siblings, is a social sistency, early transfers between families are viewed as an ex institution that is, or has been, common throughout human ante alternative when ex post investment commitments are history (Bittles, 1994; Bittles, Coble, & Rao, 1993; Hussain not credible.
    [Show full text]
  • Stern Review on the Economics of Climate Change
    STERN REVIEW: The Economics of Climate Change Preface This Review was announced by the Chancellor of the Exchequer in July 2005. The Review set out to provide a report to the Prime Minister and Chancellor by Autumn 2006 assessing: • the economics of moving to a low-carbon global economy, focusing on the medium to long-term perspective, and drawing implications for the timescales for action, and the choice of policies and institutions; • the potential of different approaches for adaptation to changes in the climate; and • specific lessons for the UK, in the context of its existing climate change goals. The terms of reference for the Review included a requirement to consult broadly with stakeholders and to examine the evidence on: • the implications for energy demand and emissions of the prospects for economic growth over the coming decades, including the composition and energy intensity of growth in developed and developing countries; • the economic, social and environmental consequences of climate change in both developed and developing countries, taking into account the risks of increased climate volatility and major irreversible impacts, and the climatic interaction with other air pollutants, as well as possible actions to adapt to the changing climate and the costs associated with them; • the costs and benefits of actions to reduce the net global balance of greenhouse gas emissions from energy use and other sources, including the role of land-use changes and forestry, taking into account the potential impact of technological advances on future costs; and • the impact and effectiveness of national and international policies and arrangements in reducing net emissions in a cost-effective way and promoting a dynamic, equitable and sustainable global economy, including distributional effects and impacts on incentives for investment in cleaner technologies.
    [Show full text]
  • Privatization—A Summary Assessment by John Nellis
    Working Paper Number 87 March 2006 Privatization—A Summary Assessment By John Nellis Abstract In the last 25 years many thousands of formerly state-owned and operated firms have been privatized in developing and transition countries, generating over $400 billion (US) in sales proceeds. In addition, thousands of firms have been transferred by privatization processes in which no money was raised (though a surprising number of state-owned firms remain in these regions). The vast majority of economic studies praise privatization’s positive impact at the level of the firm, as well as its positive macroeconomic and welfare contributions. Moreover, contrary to popular conception, privatization has not contributed to maldistribution of income or increased poverty——at least in the best-studied Latin American cases. In sum, the technical picture is generally positive. Nonetheless, public opinion in the less developed world is generally suspicious of, and often hostile to, privatization. A good part of the problem is that privatization has proven harder to launch, and is more likely to produce errant results, in low-income, institutionally weak states, particularly in the most important infrastructure sectors. Privatization is hard to sell politically; it has become a lightning rod and handy scapegoat for all discontent related to liberalization and globalization. What is needed are reform mechanisms that give incentives and comfort to reputable private investors, that create and sustain the policy and regulatory institutions that make governments competent and honest partners with the private operators, while at the same time protecting consumers, particularly the most disadvantaged, from abuse. The Center for Global Development is an independent think tank that works to reduce global poverty and inequality through rigorous research and active engagement with the policy community.
    [Show full text]
  • Frank Horace Hahn 1925–2013
    FRANK HORACE HAHN Frank Horace Hahn 1925–2013 FRANK HAHN HAD A TRANSFORMATIVE IMPACT on British economics wherever he went, building on his love of, and competence in, mathematics and greatly influenced by his numerous American colleagues. He was at the heart of the development of General Equilibrium theory, which he criti- cised for its inability to include money. As a mathematical economist he was aware of the power of maximisation to deliver testable propositions about competitive equilibrium, but he was also sceptical about competi- tive equilibrium as a useful description of any actual economy. Later he was to attack what he termed Lucasian macroeconomists (Robert Lucas and his followers) for assuming that economies were in competitive equi- librium. His published works live on along with his huge impact on the profession. He brought together and worked with the best economists of his generation, nurtured and launched his students and colleagues, and, crucially, introduced the modern American rigorous theoretical economic approach to the more literary-minded and even anti-mathematical English style that had been prevalent since Marshall. Hahn was a leader—he held the highest offices in the profession as President of the Econometric Society (in 1968), was elected to the British Academy (in 1975), and was a transformative President of the Royal Economic Society (1986–9)—but he engaged intensely with everyone and anyone willing to talk economics, whether the undergraduates that he invited weekly to his house, or his colleagues in the faculty common room at coffee and tea time, at faculty seminars and when visiting. He was hugely supportive of his friends and students, and to quote Solow on Hahn’s 1956 visit to Massachusetts Institute of Technology (MIT), Biographical Memoirs of Fellows of the British Academy, XVI, 485–525.
    [Show full text]
  • The Economic Consequences of Mr Osborne
    The Economic Consequences of Mr Osborne Victoria Chick and Ann Pettifor with Geoff Tily July 2010 (revised February 2011) including new March 2016 preface The Economic Consequences of Mr Osborne: Fiscal consolidation: Lessons from a century of UK macroeconomic statistics By Victoria Chick and Ann Pettifor with Geoff Tily Fiscal consolidation does not ‘slash’ the debt, but contributes to it, as the extent of economic recovery becomes increasingly uncertain. The authors examine a century’s worth of macroeconomic evidence to argue that contrary to conventional wisdom we need to ‘spend away the debt’. This paper was first published in July 2010, and revised in February 2011. This new edition (March 2016) includes a preface by the authors to the 2011 paper in which they look at how their analysis has fared in the light of developments since. This edition published by Policy Research in Macroeconomics in March 2016. 2 Preface – March 2016 Mr Osborne and the economists’ advice ... when sustained, fiscal consolidation increases rather than reduces the public debt ratio and is in general associated with adverse macroeconomic conditions. ‘Economic Consequences of Mr Osborne’, June 2010 Having missed the genuine threat of the private debt bubble, the economics profession misread disastrously the increase in public debt. In their 2009 This Time is Different, Kenneth Rogoff and Carmen Reinhart discreetly warned: However, the surge in government debt following a crisis is an important factor to weigh when considering how far governments should be willing to go to offset the adverse consequences of the crisis on economic activity. (290) Shortly afterward their paper ‘Growth in the Time of Debt’ set an explicit threshold of 90 per cent of GDP above which adverse economic conditions became statistically significant.
    [Show full text]
  • The Role of Financing Constraints in Patent Races
    Cash breeds Success: The Role of Financing Constraints in Patent Races∗ Enrique Schroth and Dezsö Szalay† HEC-Lausanne and FAME May 30, 2005 Abstract This paper studies the impact of cash constraints on equilibrium winning probabilities in a patent race between an incumbent and an entrant. We develop a model where cash-constrained firms finance their R&D expenditures with an investor who cannot verify their effort. In equilibrium, the incumbent faces better prospects of winning the race the less cash-constrained he is and the more cash-constrained the entrant is. We use NBER evidence from pharmaceutical patents awarded between 1975 and 1999 in the US, patent citations, and COMPUSTAT and fit probabilistic regressions of the predicted equilibrium winning probabilities on measures of the incumbent’s and potential entrants’ financial wealth. The empirical findings support our theoretical predictions. Keywords: Patent Race, incumbent, entrant, financial constraints, empirical estimation. JEL Classification: G24, G32, L13 ∗The theory presented is a much revised version of one of the second author’s dissertation chapters. We thank Mathias Dewatripont, Martin Hellwig, and Benny Moldovanu for their comments on earlier versions. This version has benefited from suggestions by Sudipto Bhattacharya, Marius Brülhart, Jean-Pierre Danthine, Bronwyn Hall, Pierre Mohnen, Tiago Ribeiro, Kurt Schmidheiny, Elu Von Thadden and Thomas Von Ungern. All errors are ours. †Address for both authors: HEC-Lausanne, BFSH-1, Department of Economics (Szalay), Department of Finance
    [Show full text]
  • Competition and Innovation: an Inverted-U Relationship
    Competition and Innovation: An Inverted-U Relationship The Harvard community has made this article openly available. Please share how this access benefits you. Your story matters Citation Aghion, Philippe, Nick Bloom, Richard Blundell, Rachel Griffith, and Peter Howitt. 2005. Competition and innovation: An inverted-U relationship. Quarterly Journal of Economics 120, no. 2: 701-728. Published Version http://dx.doi.org/10.1162/0033553053970214 Citable link http://nrs.harvard.edu/urn-3:HUL.InstRepos:4481507 Terms of Use This article was downloaded from Harvard University’s DASH repository, and is made available under the terms and conditions applicable to Other Posted Material, as set forth at http:// nrs.harvard.edu/urn-3:HUL.InstRepos:dash.current.terms-of- use#LAA COMPETITION AND INNOVATION: AN INVERTED-U RELATIONSHIP* PHILIPPE AGHION NICK BLOOM RICHARD BLUNDELL RACHEL GRIFFITH PETER HOWITT This paper investigates the relationship between product market competition and innovation. We find strong evidence of an inverted-U relationship using panel data. We develop a model where competition discourages laggard firms from innovating but encourages neck-and-neck firms to innovate. Together with the effect of competition on the equilibrium industry structure, these generate an inverted-U. Two additional predictions of the model—that the average technologi- cal distance between leaders and followers increases with competition, and that the inverted-U is steeper when industries are more neck-and-neck—are both supported by the data. I. INTRODUCTION
    [Show full text]